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You can profit from corporate greed
A strange shift is under way: Beaten-down corporate bonds have the potential to outpace common stock returns -- and with less risk. Unfortunately, investors are preoccupied with out-of-gas Treasurys.
By Timothy Middleton
Equity mutual funds suffered massive redemptions in July as investors diverted their money to high-quality bond funds, notably Treasury funds. This shift has continued this month. Investors are, as usual, blundering.
With interest rates at or near 60-year lows, There isnt a heck of a lot further to go in the bond market, says Steve Leuthold, manager of Leuthold Core Equity (LCORX). We have seen the public doing exactly the wrong thing -- storming into bonds, and at the same time abandoning stocks.
Leuthold, whose market-beating fund moves adroitly between stocks and bonds based on their relative attractiveness, has slashed his bond holdings recently and substantially increased his equity exposure.
But that doesnt mean bonds dont hold some appeal. In fact, some of them could be more attractive than stocks, even to equity investors. This week, well look at one of the most attractive groups: beaten-down corporate bonds, both investment- and below-investment-grade. Next week, well examine another pretty pair.
Investors view risks in corporate bonds as extreme, says Jack Malvey, chief global fixed-income strategist for Lehman Brothers. The result: Spreads investors can receive are very generous, he says. Theres a Ford Motor (F, news, msgs) five-year note today thats paying 500 basis points over the five-year Treasury.
And while corporate bonds have equitylike features that can contribute to capital gains when theyre in favor, theyre much safer than stocks. This is easier than picking a stock, says Ernest Monrad, co-manager of Northeast Investors (NTHEX), a premier junk-bond fund. With a stock, you have emotions, whereas we just want to get paid.
Corporate greed changed the bond market
Its little wonder that corporate bonds are in the markets doghouse. The corporate excesses that drove the stock market in the 1990s were partly paid for by bondholders.
There has been a seismic shift in how American corporations have been run over the last 10 years, says David Baldt, of Scudder Fixed Income Fund (a recent addition still awaiting a ticker symbol). Before that, bonds were rightly regarded as senior to equity on a companys balance sheet, and bondholders had corresponding power.
The proliferation of stock options in executive suites changed that corporate focus, Baldt says. Executives were finally given a vehicle to maximize their own greed as they shifted their actions to increase shareholder value. That phrase became a mantra.
The easiest way to boost a stocks price, aside from outright fraud, is to increase a companys return on equity. The quickest way to do that is to leverage the balance sheet, taking on debt to fund acquisitions, for example.
Ford has become an emblem of how debt can menace an organization.
A few years ago, Ford had a good lineup of cars, was highly profitable and had $14 billion of cash on its balance sheet, Baldt says. About that time, the equity people of the world attacked Fords management, saying that $14 billion wasnt earning much, and they needed to distribute it to shareholders or invest in something.
Ford since has spent all but $1 billion of that cash. At the same time, its competitive position has eroded, profits have disappeared and the company is so strapped for resources it is selling its European auto-parts business for a third of what it paid for it three years ago.
But as Malvey notes, Fords misery is forcing it to offer mouth-watering coupons. Baldt bit. The Scudder fund has taken a position in the 7% bonds of Ford Motor Credit that mature July 1, 2010. They were trading in recent weeks at a price of $91.83, which makes their effective yield 8.44%. At the same time, Treasurys of corresponding maturity were yielding 3.95%.
Thats a spread of 450 basis points, Baldt notes. In the 30-odd years Ive been in this business, Fords 10-year bonds would pay you an average of about 80 basis points more than Treasurys to get you to buy. This is an historic additional yield on a Ford bond today.
The Scudder fund owns about 40% more investment-grade corporate bonds than their weighting in the Lehman Aggregate Bond Index.
Those low prices are reflected in the relatively poor performance of Lehmans corporate-bond indices.
| Lehman Index Performance in % | | YTD | 2001 | 2000 | | U.S. Treasury | 7.14 | 6.75 | 13.52 | | Corporate | 2.37 | 10.31 | 9.08 | | Corporate high-yield | - 9.71 | 5.28 | - 5.86 |
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Note: As of 8/16/02
Source: Lehman Brothers
The Ford bonds are rated Triple-B, the lowest investment grade. The average American companys bonds, however, are rated somewhere along the junk spectrum. And the high-yield market is burdened with more than just sour loans.
Junk's downfall
It was the collapse of the telecommunications industry that first brought down junk. Two years ago, such bonds accounted for half the marketplace. But in recent months, a number of investment-grade telecom issues such as WorldCom (WCOEQ, news, msgs) and Qwest Communications (Q, news, msgs) have tumbled onto a market already glutted with such corporate wreckage as Enron (ENRNQ, news, msgs) and Kmart (KM, news, msgs).
With these fallen angels, the high-yield market has grown to $700 billion from $500 billion, Monrad says. So at the same time buyers are on strike, sellers are awash in inventory.
But all this bad news -- and then some -- is reflected in junk-bond prices, Monrad says. His fund, one of the few in that sector to be in the black this year, has seen its assets grow by more than one-third. And with so many bonds available, There is quite a bit you can pick and choose from.
Meanwhile, the economy is showing signs of life, and the Federal Reserve has pledged to give it CPR if necessary. The default rate, which peaked at 11%, has come down markedly, Monrad says. And though risks remain, Monrad says I think today the yields are reasonably compensatory.
Those yields extend into the low double digits. Contrast that with the 7% that noted investor Warren Buffett has predicted common stocks will return in the decade to come. The usual relationship between stocks and bonds could be turning upside down, with corporate bonds delivering better results than corporate stocks, and with much less risk.
Buy when it's bleak
Treasury bonds, meanwhile, have become ticking time bombs.
The best is behind us, Malvey says, because interest rates have come down nearly as much as they can. Two years ago, the Federal funds rate, which is the only rate the Fed can manipulate, stood at 6.5%. Last year, the Fed cut rates 11 times, to the current level of 1.75%.
While short-term rates could go below 1%, at that point you are pushing on string; you cant make people borrow. So further increases in Treasury prices, which are the reciprocal of yields, can be no more than modest.
But theres nothing modest about their risk. If the Fed funds rate were to return to 6.5%, where it was two years ago, and rates on long-term bonds rose half as much, their prices would plunge by more than 25%. Government bond funds have gotten too hot to hold.
The most dangerous bond fund of all is American Century Target Maturity 2030 (ACTAX), which owns nothing but zero-coupon Treasurys maturing that year. Its duration of 28 years means such a jump in rates would shear it of 75% of its value.
So take a good look at the bond market, even if you are an equity investor, because corporate bonds could deliver higher returns with greater safety than common stocks do in the next decade.
Then sell what it loves and buy what it hates. As with the stock market, says Baldt, its time to buy when things are blackest.
The Ford 2010 bonds, for example, could deliver total returns in the low double digits if a stronger economy results in an upgrade of its credit rating. But I wouldnt recommend buying any individual corporate bonds -- you could be buying the next WorldCom. Unless you have a lot of personal time, you probably should be using a mutual fund, Malvey says. That's true in spades of junk bonds.
Corporates arent the only attractive bonds right now. Next week well take up some government bonds --but not those of local governments --that are looking more and more attractive.
At the time of publication Timothy Middleton owned none of the securities mentioned in this article.
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